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Capital Comments: Taking Inflation Apart

Consumer price index Inflation ran at 2.1 percent per year from 1997 to 2019. Then came the pandemic recession and recovery. Inflation dropped to 1.3 percent in 2020—including 3 months of deflation, when prices were falling—then soared to 8 percent in 2022, the highest inflation rate in 40 years. The peak month was in June that year, when consumer prices averaged 8.9 percent higher than in June of 2021.

Since then inflation has come down a lot. As of November 2023, prices were 3.1 percent higher than a year before. That’s good news. 

Consumers don’t seem very happy about lower inflation, though. Perhaps that’s because lower inflation means prices are rising more slowly, when we’d really like prices to return to where they were before COVID. 

Unfortunately, that would require deflation. Deflation is rare, and comes with strings attached.  The COVID lockdown caused three months of deflation in 2020. A big drop in oil prices caused a year of deflation in 2008. The Great Depression caused four years of deflation from 1929 to 1933. Lower oil prices would be welcome, but lockdowns and depressions are certainly not. We’ll have to get used to post-COVID prices and take whatever comfort we can in smaller price increases.

The Federal Reserve’s Open Market Committee is not satisfied with lower inflation either. In their policy statement in mid-December, they said “inflation has eased over the past year but remains elevated” and “the Committee remains highly attentive to inflation risks” and “the Committee is strongly committed to returning inflation to its 2 percent objective.” Inflation is down, but not to the 2 percent target, and risks of higher inflation remain. The Fed will not be cutting interest rates until more progress is made and risks are reduced. 

One way to consider those risks is to take that 3.1 percent inflation rate apart. Let’s look at three categories of prices in the overall Consumer Price Index: durable goods, non-durable goods, and services. Consumer durables include cars, appliances, and things with screens, such as televisions, computers and smartphones. Over the 1997-2019 period, durable goods prices fell by almost 1 percent per year. Much of the price reduction reflects improving quality. For the same price, TV screens are bigger, computers are more powerful, and smartphones are smarter. Improvements in technology and factory productivity are the reasons.

Pandemic supply problems caused a jump in durable goods prices. In February 2022, prices were 19 percent higher than they’d been the year before. Supply channels have recovered since then, and as of November prices were down 1.6 percent from the year before. Goods deflation is back to normal.

Non-durable goods inflation varies up and down much more than overall inflation. The main reason is gasoline. Gasoline price per gallon averaged $1.20 in 1997, $3.25 in 2008, $2.14 in 2016, and $3.95 in 2022. The average for 2023 is $3.54. Despite all those ups and downs, overall non-durable goods inflation averaged 2 percent from 1997 to 2019, similar to overall inflation. The drop in gas prices in 2023 put the 12-month non-durable inflation rate at 0.7 percent in November. Non-durable goods inflation is back to normal.

That leaves services. Services include medical care and entertainment, but the biggest service expense is the cost of housing. The Consumer Price Index uses rents to measure the cost of housing. Service inflation averaged 2.8 percent from 1997 to 2019, but the 12-month rate as of November was 5.2 percent. Services are the price category that is holding inflation above the Fed’s 2 percent target.

And rent is keeping service inflation high. Rent inflation averaged 3.2 percent from 1997 to 2019. But the rate increased after the pandemic, peaking in March 2023 at 8.8 percent. It has fallen since then, but only to 6.9 percent. Rent tends to change about a year after other prices.  That’s partly because people sign leases that last a year or longer. Rents change only when the lease is up. 

More than anything else, the outlook for inflation depends on rents. Rent inflation has been slowly falling since March. If it keeps falling, perhaps the Fed will be persuaded that inflation risk has lessened, and will consider reductions in interest rates.

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